Inflation and investment appraisal ACCA Qualification Students

He is alsointerested in what discount rate he should be using for projectappraisal. In order to assist you the finance director has helpfullycollected data on four companies which is summarised below. This is a more complex document than Guidance Document 3, on transfer of responsibility (see above), set at a higher level of abstraction and containing fewer practical recommendations. The main issues it raises concern the amounts of financial security that will be required, the nature of the security instruments that will be accepted and the mechanisms needed to implement and oversee the whole process.

The risk-free rate is 8% and the expected return on an average market portfolio is 15%. G Brown is an established, listed company producing a range ofcentral heating systems for sale to builders’ merchants. As a result ofincreasing demand for its products, the directors have decided to expandproduction, and therefore to raise more long term finance. Pheonix is considering the purchase of a new machine to makewood-burning stoves. This predicts demand of 4,000 stoves per annum at aselling price of $750 per stove for 10 years. Theequipment will have no scrap or resale value after its expected threeyear working life.

Article 19: Financial security

It is not possible to judge, purely from the information available,whether the company has or has not met its objectives. We can see that payments to employees fell substantially after year3, together with the absolute number of employees. The average wagesper employee has fallen since year 2, suggesting that the mix ofemployees is shifting towards less-skilled workers which could bringproblems in the future. As an alternative to the above analysis it is also necessary toconsider briefly the implications of the traditional theory of gearing.This is best illustrated in its results by the following diagram. (1)The proposal’s return (IRR) is below current WACC and should be rejected.

Variable cost per stove will be $600, and in accordance with thenormal policy $250,000 of fixed overheads will be apportioned to the newproduct line per annum. A firm of environmental consultants has advised that spray paintingequipment can be installed at a cost of $4m to virtually eliminatedischarges. Unlike fines, expenditure on pollution control equipment istax-allowable via a 25% writing-down allowance (reducing balance, basedon gross expenditure). Any surplus funds may be invested in the money market to earn areturn of 9% per year. (c)The investment decision in part(a) is a closely-defined manufacturing one. Explain how a marketing oran IT investment decision might differ in terms of approach andassessment.

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It is possible that inventory has been stockpiled inanticipation of a further increase in turnover, leading to an increasein operating costs. The longer the operating cycle, the more capital is tied up andthe higher the cost to finance this capital. A company could reduce theworking capital tied up by optimising the components of the cycle.

The directors of M Co are considering opening a new factory tomanufacture a new product at a cost of $3.0 million. The current marketprice of these shares (at 31 December 20X8) is $1.45 ex-dividend. A firm’s CFROI is the internal rate of return (IRR) of these four cash flows, adjusted in current dollar terms.[8] Through focussing on all revenue streams, the CFROI expresses the evolving value of investments, hard assets and cash flows. Corporations view capital efficiency from a slightly different perspective than do traders and investors. From a business standpoint, the term is relative to incurred expenses compared to money being spent in production.[7] Once again, this concept is reminiscent of the conventional ROI formula.

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The consultant states in the report that previous clients have notinvested in countries with total weighted score of less that 30 out of amaximum possible 100 (with economic growth and political stabilitydouble weighted). The consultant therefore recommends that no investmentin Africa should be undertaken. If the scheme is organised the earnings before interest and tax is estimated to be $1 million in the first year of trading.

The availability of further funds in fiveyears’ time should be considered. (b)  Convertible loan stock provides the investor with the right,but not the obligation, to convert the loan stock into ordinary sharesat a specified future date and a specified price. The investor will onlyexercise this option if the market value of the shares is above the’exercise price’ at the specified date. The investor will change statusfrom that of lender to that of owner when the option to convert isexercised. Where a firm has regular receipts and payments in the samecurrency, it may choose to operate a foreign currency bank account. Thisoperates as a permanent matching process and the exposure to exchangerisk is limited to the net balance on the account.

Variations On The Theme Of ROI

In addition, ThorneCo will only have to pay interest on the amount of the overdraftfacility used, with the interest being charged at a variable rate linkedto bank base rate. In contrast, interest is paid on the full $200,000of the company’s bank loan whether the money is used or not. Theinterest rate on the overdraft is likely to be lower than that onlong-term debt. There istherefore a need to guard against capital loss when investing cash thatis intended to fund expansion at a later date.

• There are noincremental non-production fixed costs other than advertising costs.
• What is considered residual value varies across industries, but the core meaning is nevertheless retained.
• There’s a difference in capital budgeting techniques for foreign functions as several factors such as exchange rates, inflation rates, obstructed funds, government guidelines, etc.
• It is proposed to invest a further $1.5 million in facilities atCambridge which will increase cash flow by $150,000 to perpetuity.
• All transactions carried out with the subsidiary in SouthAfrica would be in US dollars.
• Real cash flows are found by deflating nominal cash flows by the general rate of inflation.

However, the residual value of an asset is usually calculated from the estimated salvage value of that asset. The salvage value can be estimated using the comparable approach, i.e. based on the value of comparable assets in the market. An asset’s residual value is determined based on the amount a company believes it bookkeeping for startups will realise from the sale of the asset once its useful life or lease term ends. While different industries have different residual value formulas, the meaning of residual value does not change. Of course, a question may explicitly require a nominal terms approach to be adopted, or a real terms approach, or both.

Nevertheless, the money movement computation process features different situations of exchange rate motions. If there is an understanding in the worthiness of foreign currency, it is wonderful for the parent or guardian company as it’ll improve the size of cash inflow in conditions of home currency. In today’s competitive environment, with companies want to broaden their business not only nationally but also in international markets. When planning on taking your choice on whether to invest in a foreign procedure or not the company needs to examine various options it has. Capital Budgeting techniques are being used in order to evaluate or compare different proposals.